The Pension Fund Apocalypse

The Pension Fund Apocalypse

American Institute for Economic Research

The Pension Fund Apocalypse

This is the first of two articles about negative real interest rates.

https://www.aier.org/article/pension-fund-apocalypse

pensionfund

 

 

Central bank balance sheet reductions – will anyone follow the Fed?

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Macro Letter – No 110 – 15-02-2019

Central bank balance sheet reductions – will anyone follow the Fed?

  • The next wave of QE will be different, credit spreads will be controlled
  • The Federal Reserve may continue to tighten but few other CB’s can follow
  • ECB balance sheet reduction might occur if a crisis does not arrive first
  • Interest rates are likely to remain structurally lower than before 2008

The Federal Reserve’s response to the great financial recession of 2008/2009 was swift by comparison with that of the ECB; the BoJ was reticent, too, due to its already extended balance sheet. Now that the other developed economy central banks have fallen into line, the question which dominates markets is, will other central banks have room to reverse QE?

Last month saw the publication of a working paper from the BIS – Risk endogeneity at the lender/investor-of-last-resort – in which the authors investigate the effect of ECB liquidity provision, during the Euro crisis of 2010/2012. They also speculate about the challenge balance sheet reduction poses to systemic risk. Here is an extract from the non-technical summary (the emphasis is mine): –

The Eurosystem’s actions as a large-scale lender- and investor-of-last-resort during the euro area sovereign debt crisis had a first-order impact on the size, composition, and, ultimately, the credit riskiness of its balance sheet. At the time, its policies raised concerns about the central bank taking excessive risks. Particular concern emerged about the materialization of credit risk and its effect on the central bank’s reputation, credibility, independence, and ultimately its ability to steer inflation towards its target of close to but below 2% over the medium term.

Against this background, we ask: Can central bank liquidity provision or asset purchases during a liquidity crisis reduce risk in net terms? This could happen if risk taking in one part of the balance sheet (e.g., more asset purchases) de-risks other balance sheet positions (e.g., the collateralized lending portfolio) by a commensurate or even larger amount. How economically important can such risk spillovers be across policy operations? Were the Eurosystem’s financial buffers at all times sufficiently high to match its portfolio tail risks? Finally, did past operations differ in terms of impact per unit of risk?…

We focus on three main findings. First, we find that (Lender of last resort) LOLR- and (Investor of last resort) IOLR-implied credit risks are usually negatively related in our sample. Taking risk in one part of the central bank’s balance sheet (e.g., the announcement of asset purchases within the Securities Market Programme – SMP) tended to de-risk other positions (e.g., collateralized lending from previous longer-term refinancing operations LTROs). Vice versa, the allotment of two large-scale (very long-term refinancing operations) VLTRO credit operations each decreased the one-year-ahead expected shortfall of the SMP asset portfolio. This negative relationship implies that central bank risks can be nonlinear in exposures. In bad times, increasing size increases risk less than proportionally. Conversely, reducing balance sheet size may not reduce total risk by as much as one would expect by linear scaling. Arguably, the documented risk spillovers call for a measured approach towards reducing balance sheet size after a financial crisis.

Second, some unconventional policy operations did not add risk to the Eurosystem’s balance sheet in net terms. For example, we find that the initial OMT announcement de-risked the Eurosystem’s balance sheet by e41.4 bn in 99% expected shortfall (ES). As another example, we estimate that the allotment of the first VLTRO increased the overall 99% ES, but only marginally so, by e0.8 bn. Total expected loss decreased, by e1.4 bn. We conclude that, in extreme situations, a central bank can de-risk its balance sheet by doing more, in line with Bagehot’s well-known assertion that occasionally “only the brave plan is the safe plan.” Such risk reductions are not guaranteed, however, and counterexamples exist when risk reductions did not occur.

Third, our risk estimates allow us to study past unconventional monetary policies in terms of their ex-post ‘risk efficiency’. Risk efficiency is the notion that a certain amount of expected policy impact should be achieved with a minimum level of additional balance sheet risk. We find that the ECB’s Outright Monetary Transactions – OMT program was particularly risk efficient ex-post since its announcement shifted long-term inflation expectations from deflationary tendencies toward the ECB’s target of close to but below two percent, decreased sovereign benchmark bond yields for stressed euro area countries, while lowering the risk inherent in the central bank’s balance sheet. The first allotment of VLTRO funds appears to have been somewhat more risk-efficient than the second allotment. The SMP, despite its benefits documented elsewhere, does not appear to have been a particularly risk-efficient policy measure.

This BIS research is an important assessment of the effectiveness of ECB QE. Among other things, the authors find that the ‘shock and awe’ effectiveness of the first ‘quantitative treatment’ soon diminished. Liquidity is the methadone of the market, for QE to work in future, a larger and more targeted dose of monetary alchemy will be required.

The paper provides several interesting findings, for example, the Federal Reserve ‘taper-tantrum’ of 2013 and the Swiss National Bank decision to unpeg the Swiss Franc in 2015, did not appear to influence markets inside the Eurozone, once ECB president, Mario Draghi, had made its intensions plain. Nonetheless, the BIS conclude that (emphasis, once again, is mine): –

…collateralized credit operations imply substantially less credit risks (by at least one order of magnitude in our crisis sample) than outright sovereign bond holdings per e1 bn of liquidity owing to a double recourse in the collateralized lending case. Implementing monetary policy via credit operations rather than asset holdings, whenever possible, therefore appears preferable from a risk efficiency perspective. Second, expanding the set of eligible assets during a liquidity crisis could help mitigate the procyclicality inherent in some central bank’s risk protection frameworks.

In other words, rather than exacerbate the widening of credit spreads by purchasing sovereign debt, it is preferable for central banks to lean against the ‘flight to quality’ tendency of market participants during times of stress.

The authors go on to look at recent literature on the stress-testing of central bank balance sheets, mainly focussing on analysis of the US Federal Reserve. Then they review ‘market-risk’ methods as a solution to the ‘credit-risk’ problem, employing non-Gaussian methods – a prescient approach after the unforeseen events of 2008.

Bagehot thou shouldst be living at this hour (with apologies to Wordsworth)

The BIS authors refer on several occasions to Bagehot. I wonder what he would make of the current state of central banking? Please indulge me in this aside.

Walter Bagehot (1826 to 1877) was appointed by Richard Cobden as the first editor of the Economist. He is also the author of perhaps the best known book on the function of the 19th century money markets, Lombard Street (published in 1873). He is famed for inventing the dictum that a central bank should ‘lend freely, at a penalty rate, against good collateral.’ In fact he never actually uttered these words, they have been implied. Even the concept of a ‘lender of last resort’, to which he refers, was not coined by him, it was first described by Henry Thornton in his 1802 treatise – An Enquiry into the Nature and Effects of the Paper Credit of Great Britain.

To understand what Bagehot was really saying in Lombard Street, this essay by Peter Conti-Brown – Misreading Walter Bagehot: What Lombard Street Really Means for Central Banking – provides an elegant insight: –

Lombard Street was not his effort to argue what the Bank of England should do during liquidity crises, as almost all people assume; it was an argument about what the Bank of England should openly acknowledge that it had already done.

Bagehot was a classical liberal, an advocate of the gold standard; I doubt he would approve of the nature of central banks today. He would, I believe, have thrown his lot in with the likes of George Selgin and other proponents of Free Banking.

Conclusion and Investment Opportunities

Given the weakness of European economies it seems unlikely that the ECB will be able to follow the lead of the Federal Reserve and raise interest rates in any meaningful way. The unwinding of, at least a portion of, QE might be easier, since many of these refinancing operations will naturally mature. For arguments both for and against CB balance sheet reduction this paper by Charles Goodhart – A Central Bank’s optimal balance sheet size? is well worth reviewing. A picture, however, is worth a thousand words, although I think the expected balance sheet reduction may be overly optimistic: –

http___com.ft.imagepublish.upp-prod-eu.s3.amazonaws

Source: IMF, Haver Analytics, Fulcrum Asset Management

Come the next crisis, I expect the ECB to broaden the range of eligible securities and instruments that it is prepared to purchase. The ‘Draghi Put’ will gain greater credence as it encompasses a wider array of credits. The ‘Flight to Quality’ effect, driven by swathes of investors forsaking equities and corporate bonds, in favour of ‘risk-free’ government securities, will be shorter-lived and less extreme. The ‘Convergence Trade’ between the yields of European government bonds will regain pre-eminence; I can conceive the 10yr BTP/Bund spread testing zero.

None of this race to zero will happen in a straight line, but it is important not to lose sight of the combined power of qualitative and quantitative easing. The eventual ‘socialisation’ of common stock is already taking place in Japan. Make no mistake, it is already being contemplated by a central bank near you, right now.

Is the US exporting a recession?

Is the US exporting a recession?

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Macro Letter – No 96 – 04-05-2018

Is the US exporting a recession?

  • The Federal Reserve continue to raise rates as S&P earnings beat estimates
  • The ECB and BoJ maintain QE
  • Globally, corporations rely on US$ financing, nonetheless
  • Signs of a slowdown in growth are clearer outside the US

After last week’s ECB meeting, Mario Draghi gave the usual press conference. He confirmed the continuance of stimulus and mentioned the moderation in the rate of growth and below-target inflation. He also referred to the steady expansion in money supply. When it came to the Q&A he revealed rather more:-

It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries.

It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators. Sharp declines were experienced by PMI, almost all sectors, in retail, sales, manufacturing, services, in construction. Then we had declines in industrial production, in capital goods production. The PMI in exports orders also declined. Also we had declines in national business and confidence indicators.

I quote this passage out of context because the entire answer was more nuanced. My reason? To highlight the difference between the situation in the EU and the US. In Europe, money supply (M3) is growing at 4.3% yet inflation (HICP) is a mere 1.3%. Meanwhile in the US, inflation (CPI) is running at 2.4% and money supply (M2) is hovering a fraction above 2%. Here is a chart of Eurozone M3 since 1999:-

EU M3 Money Supply

Source: Eurostat

The recent weakening of momentum is a concern, but the absolute level is consistent with a continued expansion.

Looked at over a rather longer time horizon, here is a chart of US M2 since 1900:-

M2 since 1900 - Hoisington

Source: Hoisington Asset Management, Federal Reserve

The letters A, B, C, D denote the only occasions, during the last 118 years, when a decline in the expansion (or, during the 1930’s, contraction) of M2 did not lead to a recession. 17 out of 21 is a quite compelling record.

Another concern for markets is the flatness of the US yield curve. Here is the 2yr – 10yr yield differential since 1990:-

US 2yr - 10yr Factset Mauldin

Source: Factset, Mauldin Economics

More importantly, for international borrowers, the 6-month LIBOR rate has risen by more than 60 basis points since the start of the year (from 1.8% to 2.5%) whilst 30yr Swap rates have increased by only 40 basis points (2.6% to 3%). The 10yr – 30yr Swap curve is now practically flat.

Also worthy of comment, as US Treasury yields have risen, the relationship between Bonds and Swaps has begun to normalise – 30yr T-Bond yields are only 40 basis points above their level of January and roughly at the same level as in the spring of last year. In April 2017 I wrote in Macro Letter – No 74 – US 30yr Swaps have yielded less than Treasuries since 2008 – does it matter?:-

Today the IRS market increasingly determines the cost of finance, during the next crisis IRS yields may rise or fall by substantially more than the same maturity of US T-bond, but that is because they are the most liquid instruments and are only indirectly supported by the Central Bank.

It looks like I may have to eat my words, here is the Bond vs Swap table revisited:-

Evolution_of_T-Bond_and_IRS_Spreads_-_investing_co_002

Source: Investing.com, Interestrateswaps.com, BBA

What is evident is that the Bond/Swap inversion in the longer maturities has closed substantially even as shorter maturity spreads have narrowed. Federal Reserve policy has been the dominate factor.

Why is it, however, that the effect of higher US rates is, seemingly, felt more poignantly in Europe than the US? Does this bring us back to protectionism? Perhaps, but in less contentious terms, the US has run a capital account surplus for many years. Outside the US investment is closely tied to LIBOR financing costs, these have remained higher, except in the longest maturities, and these rates have risen most precipitously this year. Looked at another way, the higher interest rate policies of the Federal Reserve, despite the continued largesse of other central banks, is exporting the next recession to the rest of the world.

I ended Macro Letter – No 74 back in April 2017 – saying:-

Meanwhile, although interest rates have risen from historic lows they remain far below their long run average. Pension funds and other long-term investors still require 7% or more in annualised returns in order to meet their liabilities. They are being forced to continuously increase their investment risk and many have chosen to use the swap market. The next crisis is likely to see an even more pronounced unravelling than in 2008/2009. The unravelling may not happen for some while but the stresses are likely to be focused on the IRS market.

One year on, cracks in the capital markets edifice are beginning to become more evident. GDP growth has started to rollover in the US, Eurozone and Japan. Yields are still relatively low but the absolute increase in rates for shorter maturities (e.g. the near doubling of US 2yr yields from 1.25% to 2.5% in a single year) is guaranteed to take its toll on corporate interest servicing costs. US capital markets are the envy of the world. They are deep and allow borrowers to finance far into the future. The rest of the world is forced to borrow at shorter tenors. A three basis point narrowing of 5yr spreads between Swaps and Bonds is hardly compensation for the near 1% increase in interest rates, or, put in starker terms, a 46% increase in absolute borrowing costs.

Conclusion and investment opportunities

How is the rise in borrowing costs impacting the US stock market? Volatility is back, but earnings are robust. Factset – S&P 500 Earnings Season Update: April 27, 2018 – described it thus:-

To date, 53% of the companies in the S&P 500 have reported actual results for Q1 2018. In terms of earnings, more companies are reporting actual EPS above estimates (79%) compared to the five-year average. If 79% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting actual EPS above estimates since FactSet began tracking this metric in Q3 2008. In aggregate, companies are reporting earnings that are 9.1% above the estimates, which is also above the five-year average. In terms of sales, more companies (74%) are reporting actual sales above estimates compared to the five-year average. In aggregate, companies are reporting sales that are 1.7% above estimates, which is also above the five-year average. If 1.7% is the final percentage for the quarter, it will mark the largest revenue surprise percentage since FactSet began tracking this metric in Q3 2008.

… The blended (combines actual results for companies that have reported and estimated results for companies that have yet to report), year-over-year earnings growth rate for the first quarter is 23.2% today, which is higher than the earnings growth rate of 18.5% last week. Positive earnings surprises reported by companies in multiple sectors (led by the Information Technology sector) were responsible for the increase in the earnings growth rate for the index during the past week. All 11 sectors are reporting year-over-year earnings growth. Nine sectors are reporting double-digit earnings growth, led by the Energy, Materials, Information Technology, and Financials sectors.

We are more than halfway through Q1 earnings (I’m writing this letter on Wednesday 2nd May). Results have generally been above forecast and now the Fed seems conscious that they must not be too hasty to reverse the effects of both zero rates and QE. Added to which, while US stocks have been languishing mid-range, European stocks have recently broken out of their recent ranges to the upside, despite discouraging economic data.

The US stock market looks less expensive than it did in January 2017, when I wrote Macro Letter – 68 – Equity valuation in a de-globalising world. Then I was looking for stock markets with a low correlation to the US: they were (and remain) hard to find.

Other indicators to watch which exert a strong influence on stocks include the US PMI Index – last at 54.8 up from 54.2 in March. Above 50 there is little cause for concern. For the Eurozone it is even higher at 55.2, whilst throughout G20 no economy is recording a PMI below 50.

The chart below shows the Citigroup Economic Surprises Index (blue) vs the S&P500 Forward P/E estimates (red):-

Citi Economic Surprises vs SandP - Yardeni 27-4-18

Source: Yardeni Research, S&P, Thompson Reuters, Citigroup

Economic surprises remain positive rather than negative for the US. In the Eurozone it is quite another matter:-

Citigroup Economic Surprises Index - Eurozone

Source: Bloomberg, Citigroup

A number of economic indicators are pointing to a slowdown, yet US stocks are beating estimates. To judge from price action, the market appears to be unimpressed by earnings. I am reminded of the old adage, ‘When all the buyers are in the market it’s time to sell.’ From a technical perspective it makes sense to be patient, but the market has failed to rise substantially on a positive slew of earnings news. This may be because there is a more important factor driving sentiment: the direction of US rates. It certainly appears to have engendered a revival of the US$. It rallied last month having been in a downtrend since January 2017 despite a steadily tightening Federal Reserve. For EURUSD the move from 1.10 to 1.25 appears to have taken its toll. On the basis of the CESI chart, above, if Wall Street sneezes, the Eurozone might catch pneumonia.

Are we nearly there yet? Employment, interest rates and inflation

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Macro Letter – No 92 – 09-03-2018

Are we nearly there yet? Employment, interest rates and inflation

  • Rising interest rates and inflation are spooking financial markets
  • Unemployment data suggests that labour markets are tight
  • Central Banks will have to respond to a collapse in the three asset bubbles

There are two factors, above all others, which are spooking asset markets at present, inflation and interest rates. The former is impossible to measure with any degree of certainty – for inflation is in the eye of the beholder – and the latter is divergent depending on whether you look at the US or Japan – with Europe caught somewhere between the two extremes. In this Macro Letter I want to investigate the long term, demand-pull, inflation risk and consider what might happen if stocks, bonds and real estate all collapse in tandem.

It is reasonable to assume that US rates will rise this year, that UK rates might follow and that the ECB (probably) and BoJ (almost certainly) will remain on the side-lines. An additional worry for export oriented countries, such as Japan and Germany, is the protectionist agenda of the current US administration. If their exports collapse, GDP growth is likely to slow in its wake. The rhetoric of retaliation will be in the air.

For international asset markets, the prospect of higher US interest rates and protectionism, spells lower growth, weakness in employment and a lowering of demand-pull inflationary pressure. Although protectionism will cause prices of certain goods to rise – use that aluminium foil sparingly, baste instead – the overall effect on employment is likely to be swift.

Near-term impact

Whilst US bond yields rise, European bond yields may fail to follow, or even decline, if export growth collapses. Stocks in the US, by contrast, may be buoyed by tax cuts and the short-term windfall effect of tariff barriers. The high correlation between equity markets and the international nature of multinational corporations, means global stocks may remain levitated a while longer. The momentum of recent economic growth may lead to increased employment and higher wages in the near-term – and this might even spur demand for a while – but the spectre of inflation at the feast, will loom like a hawk.

Longer-term effects

But is inflation really going to be a structural problem? In an attempt to answer this we must delve into the murky waters of the employment data. As a starting point, at what juncture can we be confident that the US and other countries at or near to full-employment? Let us start by looking at the labour force participation rate. It is a difficult measure to interpret. As the table below shows, in the US and Japan the trend has been downward whilst the UK and the EU are hitting record highs:-

Labor_Force_Participation_Rates

Source: Trading Economics

One possible reason for this divergence between the EU and the US/Japan is that the upward trend in European labour participation has been, at least partially, the result of an inexorable reduction in the scope and scale of the social safety net throughout the region.

More generally, since the Great Recession of 2008/2009 a number of employment trends have been evident across most developed countries. Firstly, many people have moved from full-time to part-time employment. Others have switched from employment to self-employment. In both cases these trends have exerted downward pressure on earnings. What little growth in earnings there has been, has mainly emanated from the public sector, but rising government deficits make this source of wage growth unsustainable in the long run.

The Record of Meeting of the CAC and Federal Reserve Board of Governors – published last November, stated the following in relation to US employment:-

The data indicate that despite the drop in unemployment, there has not been an increase in the number of quality jobs—those that pay enough to cover expenses and enable workers to save for the future. The 2017 Scorecard reports that one in four jobs in the U.S. is in a low-wage occupation, which means that at the median salary, these jobs pay below the poverty threshold for a family of four. For the first time, the 2017 Scorecard includes a measure of income volatility that shows that one in five households has significant income fluctuations from month to month. The percentage varies by state, from a low of 14.7 percent of households in Virginia to a stunning 29.8 percent of households in Wyoming. In addition, 40 percent of those experiencing volatility reported struggling to pay their bills at least once in the last year because of these income fluctuations. These two factors contribute significantly to the fact that almost 37 percent of U.S. households, and 51 percent of households of color, live in the financial red zone of “liquid asset poverty.” This means that they do not have enough liquid savings to replace income at the poverty level for three months if their main source of income is disrupted, such as from job loss or illness. This level of financial insecurity has profound implications for the security of households, and for the overall economic growth of the nation.

Another trend that has been evident is the increase in the number of people no longer seeking employment. Setting aside those who, for health related reasons, have exited the employment pool, early retirement has been one of the main factors swelling the ranks of the previously employable. For this growing cohort, inflation never went away. In particular, inflation in healthcare has been one of the main sources of increases in the price level over the past decade.

At the opposite end of the working age spectrum, education is another factor which has reduced the participation rate. It has also exerted downward pressure on wages; as more students enrol in higher education in order to gain, hopefully, better paid employment, the increased supply of graduates insures that the economic value of a degree diminishes. Whilst a number of corporations have begun to offer apprenticeships or in-work degree qualifications, in order to address the skill gap between what is being taught and what these firms require from their employees, the overall impact of increased demand for higher education has been to reduce the participation rate.

For a detailed assessment of the situation in the US, this paper from the Kansas City Federal Reserve – Why Are Prime-Age Men Vanishing from the Labor Force? provides some additional and fascinating insights. Here is the author’s conclusion:-

Over the past two decades, the nonparticipation rate among primeage men rose from 8.2 percent to 11.4 percent. This article shows that the nonparticipation rate increased the most for men in the 25–34 age group and for men with a high school degree, some college, or an associate’s degree. In 1996, the most common situation prime-age men reported during their nonparticipation was a disability or illness, while the least common situation was retirement. While the share of primeage men reporting a disability or illness as their situation during nonparticipation declined by 2016, this share still accounted for nearly half of all nonparticipating prime-age men. This result is in line with Krueger’s (2016) finding, as many of these men with a disability or illness are likely suffering from daily pain and using prescription painkillers.

I argue that a decline in the demand for middle-skill workers accounts for most of the decline in participation among prime-age men. In addition, I find that the decline in participation is unlikely to reverse if current conditions hold. In 2016, the share of nonparticipating prime-age men who stayed out of the labor force in the subsequent month was 83.8 percent. Moreover, less than 15 percent of nonparticipating prime-age men reported that they wanted a job. Together, this evidence suggests nonparticipating prime-age men are less likely to return to the labor force at the moment.

The stark increase in prime-age men’s nonparticipation may be the result of a vicious cycle. Skills demanded in the labor market are rapidly changing, and automation has rendered the skills of many less-educated workers obsolete. This lack of job opportunities, in turn, may lead to depression and illness among displaced workers, and these health conditions may become further barriers to their employment. Ending this vicious cycle—and avoiding further increases in the nonparticipation rate among prime-age men—may require equipping workers with the new skills employers are demanding in the face of rapid technological advancements.

For an even more nuanced interpretation of the disconnect between corporate profits and worker compensation this essay by Jonathan Tepper of Varient Perception – Why American Workers Aren’t Getting A Raise: An Economic Detective Story – is even more compelling:-

Rising industrial concentration is a powerful reason why profits don’t mean revert and a powerful explanation for the imbalance between corporations and workers. Workers in many industries have fewer choices of employer, and when industries are monopolists or oligopolists, they have significant market power versus their employees.

The role of high industrial concentration on inequality is now becoming clear from dozens recent academic studies. Work by The Economist found that over the fifteen-year period from 1997 to 2012 two-thirds of American industries were more concentrated in the hands of a few firms. In 2015, Jonathan Baker and Steven Salop found that “market power contributes to the development and perpetuation of inequality.”

One of the most comprehensive overviews available of increasing industrial concentration shows that we have seen a collapse in the number of publicly listed companies and a shift in power towards big companies. Gustavo Grullon, Yelena Larkin, and Roni Michaely have documented how despite a much larger economy, we have seen the number of listed firms fall by half, and many industries now have only a few big players. There is a strong and direct correlation between how few players there are in an industry and how high corporate profits are.

Tepper goes on to discuss monopolies and monopsonies. At the heart of the issue is the zombie company phenomenon. With interest rates at artificially low levels, companies which should have been liquidated have survived. Others have used their access to finance, gained from many years of negotiation with their bankers, to buy out their competitors. If interest rates were correctly priced this would not have been possible – these zombie corporations would have gone to the wall. I wrote a rather long two part essay on this subject in 2016 for the Cobden Centre – A history of Fractional Reserve Banking – or why interest rates are the most important influence on stock market valuations? This is about the long-run even by my standards but I commend it to those of you with an interest in economic history. Here is a brief quote from part 2:-

…This might seem incendiary but, let us assume that the rate of interest at which the UK government has been able to borrow is a mere 300bp below the rate it should have been for the last 322 years – around 4% rather than 7%. What does this mean for corporate financing?

There are two forces at work: a lower than “natural” risk free rate, which should make it possible for corporates to borrow more cheaply than under unfettered conditions. They can take on new projects which would be unprofitable under normal conditions, artificially prolonging economic booms. The other effect is to allow the government to crowd out private sector borrowing, especially during economic downturns, where government borrowing increases at the same time that corporate profitability suffers. The impact on corporate interest rates of these two effects is, to some extent, self-negating. In the long run, excessive government borrowing permanently reduces the economic capacity of the country, by the degree to which government investment is less economically productive than private investment.

To recap, more people are remaining in education, more people are working freelance or part-time and more people are choosing to retire early. The appreciation of the stock, bond and property markets has certainly helped those who are asset rich, choose to exit the ranks of the employable, but, I suspect, in many cases this is only because asset prices have been rising for the past decade. Pension annuity rates appear to have hit all-time lows, a reckoning for asset markets is overdue.

What happens come the next bust and beyond?

If inflation rises and Central Banks respond by raising interest rates, bond prices will fall and stocks will have difficulty avoiding the force of gravity. Once bond and stock markets fall, property prices are likely to follow, as the cost of financing mortgages increases. With all the major asset classes in decline, economic growth will slow and unemployment will rise. Meanwhile, the need to work, in order to supplement the reduction in income derived from a, no longer appreciating, pool of assets, will increase, putting downward pressure on average earnings. Here is the most recent wage, inflation and real wage data. For France, Germany and the UK, wages continue to lag behind prices. A 2% inflation target is all very well, just so long as wages can keep up:-

Wages_and_Inflation

Source: Trading Economics

The first place where this trend in lower earnings will become evident is likely to be among freelance and part-time workers – at least they will still have employment. The next casualty will be the fully employed. Corporations will lay-off staff as corporate profit warnings force their hands. Governments will be beseeched to create jobs and, regardless of whether the inflation rate is still rising or not, Central Banks will be implored, cajoled (whatever it takes) to cut interest rates and renew their quest to purchase every asset under the sun.

Wage deflation will, of course, continue, harming those who have no alternative but to work; those who lack sufficient unearned income to survive. Government debt will accelerate, Central Bank balance sheets will balloon and asset prices will eventually recover. Bond yields may even reach new record lows, prompting assets to flow into stocks – the ones Central Banks have not yet purchased as part of their QQE programmes – despite their inflated valuations. Corporate executives will no doubt take the view that interest rates are artificially low and conclude that they can best serve their shareholders by buying back their own stock – accompanied by the occasional special dividend to avoid accusations for impropriety.

As economic growth takes a nose drive, inflation will moderate, providing justification for the pre-emptive rate cutting and balance sheet expanding actions of the Central Banks. Articles will begin to appear, in esteemed journals, talking of a new era of low economic trend growth. Finally, after several years of QE, QQE and whatever the stage beyond that may be – helicopter money anyone? – the world economy will start to grow more rapidly and the labour force participation rate, increase once more. Inflation will start to rise, interest rates will be tightened, bond yields, increase. At this point, stocks will fall and the next downward leg of the economic cycle will have to be averted by renewed QQE and fiscal stimulus. If this is reminiscent of a scene from Groundhog Day, I regret to inform you, it is.

There will be a point at which the financialisation of the global economy and the nationalisation of the stock market can no longer deliver the markets from the deleterious curse of debt, but, sadly, I do not believe that moment has yet arrived. Are we nearly there yet? Not even close.

 

Japan – Politics, Central Banking and the Nikkei 225

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Macro Letter – No 84 – 29-09-2017

Japan – Politics, Central Banking and the Nikkei 225

  • PM Abe called a snap general election for October, amid rising geopolitical tensions
  • The BoJ maintain QQE despite Federal Reserve plans to reduce its balance sheet
  • Japanese stocks will benefit if the ‘Three Arrows’ of Abenomics continue
  • Japanese wages are rising whilst inflation is stuck at zero

On Monday Japanese Prime Minister, Shinzo Abe, called a snap general election. During the press conference in which he made the announcement he said:-

It is my mission as prime minister to exert strong leadership abilities at a time when Japan faces national crises stemming from the shrinking demographic and North Korea’s escalating tensions…

He went on to outline a JPY 2trln stimulus package, to be implemented before year end. This will be financed by raising the consumption tax rate from 8% to 10% in October 2019. The tax increase is expected to generate JPY 5trln/annum and, if any revenue remains after the stimulus, it will be used to reduce government debt. With a further JPY 2trln earmarked for education and social programmes it seems unlikely the maths will add up.

Meanwhile, despite the Federal Reserve’s announcement, last week, that they will begin balance sheet reduction, the Bank of Japan (BoJ) continue their policy of quantitative and qualitative easing (QQE) involving the unorthodox ‘yield curve control’ measures. From more on this please see Macro Letter – No 65 – Yield Curve Control – the road to infinite QE which I published in November 2016. I stand by my conclusion, although my prediction about the JPY (I thought it would continue to weaken) has yet to come to pass:-

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

In the long run demographic forces may halt Abenomic attempts to debase the Yen. This 2015 paper from the Federal Reserve Bank of St Louis – Aging and the Economy: The Japanese Experience – makes fascinating reading. Here is a snippet, but I urge you to read the whole article for an overview of the impact of an ageing population on economies in general, Japan exhibits some unique characteristics in this respect:-

In a third study, economists Derek Anderson, Dennis Botman and Ben Hunt found that the increased number of pensioners in Japan led to a sell-off of financial assets by retirees, who needed the money to cover expenses. The assets were mostly invested in foreign bonds and stocks. The sell-off, in turn, fueled appreciation of the yen, lowering costs of imports and leading to deflation.

Returning to the current environment, on Monday, in a speech to business leaders in Osaka entitled – Japan’s Economy and Monetary PolicyBoJ Governor Haruhiko Kuroda made several observations about the economy, labour market and inflation:-

The economy is expanding moderately, and the real GDP growth rate for the April-June quarter registered a firm increase of 2.5 percent on an annualized basis. It is the first time in eleven years, since 2006, that it has continued to mark positive growth for six consecutive quarters…

The year-on-year rate of increase in hourly wages of part-time employees, which are particularly sensitive to the tightening of the labor market, has registered about 2.5 percent. This is higher than that of full-time employees, implying that the difference in wage levels between part-time and full-time employees has become smaller…

In the labor market as a whole, the unemployment rate has declined to around 3 percent, which is equivalent to virtually full employment, and the active job openings-to-applicants ratio stands at 1.52, exceeding the highest figure during the bubble period and reaching a level last seen as far back as in 1974…

The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has increased to around 0.5 percent recently, but that which also excludes the effects of a rise in energy prices has been relatively weak, remaining at around 0 percent…

Kuroda-san went on to defend the BoJ 2% inflation target and explain the logic behind their ‘QQE with Yield Curve Control’ mechanism. I am struck by the improving affluence of the average worker in Japan. Inflation is zero whilst wage growth, except for the dip in July to -0.3%, has been positive for most of this decade. Real Japanese wages have been rising which is in stark contrast to many of its G7 peers. See Pew Research – For most workers, real wages have barely budged for decades for more on this subject.

The minutes of the July 19th/20th BoJ – Monetary Policy Meeting – were released on Tuesday.  They left policy unchanged. The short-term interest rate target at -0.10% and the long-term rate (10yr JGB yield) at around zero. Commenting on the economy they noted continued solid investment, especially by larger firms and the sustained improvement in private consumption. The consumption activity index (CAI) for Q1 2017 showed a fourth consecutive quarterly increase. I was interested in the statement highlighted below (the emphasis is mine):-

…members shared the view that, with corporate profits improving, which mainly reflected the growth in overseas economies, business fixed investment plans were becoming solid on the whole. They also shared the recognition that the employment and income situation had improved steadily and private consumption had increased its resilience. Members then concurred that a positive output gap had taken hold, given the recent tightening of labor market conditions and the increase in capacity utilization rates, with the latter reflecting a rise in production. Based on this discussion, they agreed to revise the Bank’s economic assessment upward to one stating that Japan’s economy “is expanding moderately, with a virtuous cycle from income to spending operating” from the previous one stating that the economy “has been turning toward a moderate expansion.” One member pointed out that Japan’s economy was shifting from a recovery dependent on external demand to a more self-sustaining expansion brought about by an improvement in domestic demand. This member continued that it was also becoming evident that improvements in economic activity had been spreading across a wider range of areas, urban to regional.

The current QQE policies were reconfirmed (emphasis mine):-

With regard to the amount of JGBs to be purchased, it would conduct purchases at more or less the current pace — an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen — aiming to achieve the target level of the long-term interest rate specified by the guideline.

With regard to asset purchases other than JGB purchases, many members shared the recognition that it was appropriate for the Bank to implement the following guideline for the intermeeting period. First, it would purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding would increase at annual paces of about 6 trillion yen and about 90 billion yen, respectively. Second, as for CP and corporate bonds, it would maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

An independent summation of the current environment and the prospects for the Japanese economy comes from an article by Kazumasa Iwata – President of the Japan Center for Economic Research – AJISS – The Future of the Japanese Economy: The Great Convergence and Two Great Unwindings:-

Since bottoming out in November 2012, the Japanese economy has been in an expansionary phase that reached its 58th month in September of this year. Although not yet as long as the economic expansion achieved during the Koizumi reforms (73 months), the current phase exceeded the mark set by the Izanagi boom of the late 1960s (57 months). While this phase is technically termed expansionary, it lacks strength. In contrast to the average growth rate of 1.8% seen during the Koizumi reforms, the average rate in the ongoing expansion has only been about 1%.

The economic strategy underlying Abenomics is to put the Japanese economy on the road to 2% growth. The experiences of the Koizumi reforms demonstrate that it is quite possible to realize 2% growth by implementing an effective growth strategy. This is evidenced by the theory of convergence through technology diffusion. The catch-up attained by China, India and other emerging countries since the 1990s through offshoring and the construction of global value chains has been astounding. Professor Richard Baldwin argues that the start of the Industrial Revolution ushered in an era of Great Divergence for the global economy via technological innovation and capital accumulation in the developed countries and elsewhere, and that from the 1990s we have been in an age of Great Convergence due to rapid drops in information and telecommunications costs.

In contrast to the brisk development enjoyed by emerging countries, Japan has found itself in a two-decade-long period of stagnation, its economy falling far below the convergence line predicted by Convergence Theory…

Japan already failed to boost its productivity during the 1st IT Revolution of the mid-1990s, and it is now in the 2nd IT Revolution, otherwise known as the 4th Industrial Revolution, centered on IoT, AI, and Big Data. OECD research shows that the top 5% frontier companies have not seen a decline in productivity growth since the financial crisis. Other companies lag behind these frontier companies in globalizing and using digital technology (digitalization), which has only widened the productivity gap between them. Were all companies in Japan able to boost their performance on par with the top ten companies utilizing AI and IoT, Japan’s growth rate could be accelerated by 4% (JCER 2017).

It is interesting to note that Iwata-san sees the greatest risk coming from the unwinding of QE by the Federal Reserve and the ECB, combined with the increasingly protectionist stance of US trade policy. He does not appear to expect the BoJ to reverse QQE, nor Abenomics to falter.

Market Impact

What does the forthcoming election and continuation of infinite QQE mean for Japanese financial markets? Firstly here are three 10 year charts, of the USDJPY, 10yr JGBs and the Nikkei 225:-

USDJPY 10yr - monthly - Tradingeconomics

Source: Trading Economics

!0yr JGB - 10yr monthly - Tradingeconomics

Source: Trading Economics

Nikkei 225 - 10yr monthly - Tradingeconomics

Source: Trading Economics

The Yen has been trading a range this year; it has strengthened against a generally weakening US$, whilst weakening against a resurgent Euro. 10yr JGBs have been held in an effective straightjacket by ‘Yield curve control’. Meanwhile the Nikkei 225 has followed the lead of other equity markets, both in Asia and the US, and marched steadily higher. A break above the highs of August 2015 would see the index trading at its highest since 1997. A dividend yield of 2% (source: Star Capital – as at 30/6/2017) looks attractive compared to JGBs or inflation, although a P/E ratio of more than 17 times and a CAPE ratio above 26 may be cause for caution.

An assessment of financial markets would not be complete without a review of real estate. The BoJ mentioned that house prices have been fairly flat this year. Below is a r chart of the Japan Housing Index and the CPI Index since the financial crisis of 2008:-

Japan Housing Price Index and CPI 10yr Trading Economics

Source: Trading Economics, Japan Ministry of Internal Affairs

Real Estate rental yields are currently around 2.5% making property an alternative to stocks for the long term investor. Personally, with dividend yields around 2%, I would want more than 50 basis points to invest in such an illiquid asset: chacun a son gout.

The Geopolitics of North Korea makes Japan vulnerable: Japan’s currency will bear the brunt of this. Given that much of the recent economic growth has been export led, this Yen weakness is unlikely to damage the prospects for the stock market, except perhaps in the short-term.

If Abe wins a convincing mandate on 22nd October, military spending may be added to the mix of public sector stimulus. Pervious consumption tax increases have proved damaging to the nascent economic recovery, this time, dare I say it, might be different. With wages increasing and domestic demand finally beginning to rise, a moderate tax hike maybe achievable, although I still think it more likely that implementation will be deferred.

The table below, which shows the top 10 best value stocks in the Nikkei, was calculated on 28th April. It is produced by Obermatt – click on the name to find out more about Obermatt’s excellent range of services and their valuation methodologies:-

Nikkei_225_-_Top_10_-_Obermatt_-_28-4-2017

Source: Obermatt 

To be clear, being a top-down macro investor, I have not personally delved into the relative merits of the stocks above, but I am comforted to note that most of them are household names, even outside Japan. A testament to the quality of many Japanese corporations.

From a technical perspective one should have bought the chart breakout back in November 2016. The market is close to resistance at 21,000 and I would like to see a monthly close above this level before risking additional capital, however, after nearly three decades of deflationary adjustment, the Japanese economy may be beginning to find sustainable growth. I believe this is despite, rather than as a result of, government and central bank policy: but that’s a topic for another time.

 

 

Central Bank balance sheet adjustment – a path to enlightenment?

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Macro Letter – No 79 – 16-6-2017

Central Bank balance sheet adjustment – a path to enlightenment?

  • The balance sheets of the big four Central Banks reached $18.4trln last month
  • The Federal Reserve will commence balance sheet adjustment later this year
  • The PBoC has been in the vanguard, its experience since 2015 has been mixed
  • Data for the UK suggests an exit from QE need not precipitate a stock market crash

The Federal Reserve (Fed) is about to embark on a reversal of the Quantitative Easing (QE) which it first began in November 2008. Here is the 14th June Federal Reserve Press Release – FOMC issues addendum to the Policy Normalization Principles and Plans. This is the important part:-

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

On the basis of their press release, the Fed balance sheet will shrink until it is nearer $2.5trln versus $4.4trln today. If they stick to their schedule that should take until the end of 2021.

The Fed is likely to be followed by the other major Central Banks (CBs) in due course. Their combined deleveraging is unlikely to go unnoticed in financial markets. What are the likely implications for bonds and stocks?

To begin here are a series of charts which tell the story of the Central Bankers’ response to the Great Recession:-

Central_Bank_Balance_Sheets_-_Yardeni_May_2017

 Source: Yardeni Research, Haver Analytics

Since 2008 the balance sheets of the four major CBs have grown from around $6.5trln to $18.4trln. In the case of the People’s Bank of China (PBoC), a reduction began in 2015. This took the form of a decline in its foreign exchange reserves in order to support the weakening RMB exchange rate against the US$. The next chart shows the path of Chinese FX reserves and the Shanghai Stock index since the beginning of 2014. Lagged response or coincidence? Your call:-

China FX reserves and stocks 2014 - 2017

Source: Trading Economics

At a global level, the PBoC balance sheet reduction has been more than offset by the expansion of the balance sheets of the Bank of Japan (BoJ) and European Central Bank (ECB), however, a synchronous balance sheet contraction by all the major CBs is likely to be of considerable concern to financial market participants globally.

An historical perspective

Have CB balance sheets ever been as large as they are today? Indeed they have. The chart below which terminates in 2011, shows the evolution of the Fed balance sheet since its inception in 1913:-

Federal_Reserve_Balance_Sheet_-_History_-_St_Louis

Source: Federal Reserve, Haver Analytics

The increase in the size of the Fed balance sheet during the period of the Great Depression and WWII was related to a number of factors including: gold inflows, what Friedman and Schwartz termed “precautionary demand” for reserves by commercial banks, lack of alternative assets, changes in reserve requirements, expansion of income and war financing.

For a detailed review of all these factors, this paper from 2016 – How was the Quantitative Easing Program of the 1930s Unwound? By Matthew Jaremski and Gabriel Mathy – makes fascinating reading, here’s the abstract:-

Outside of the recent past, excess reserves have only concerned policymakers in one other period: The Great Depression of the 1930s. This historical episode thus provides the only guidance about the Fed’s current predicament of how to unwind from the extensive Quantitative Easing program. Excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed banks to naturally reduce their excess reserves. Excess reserves fell rapidly in 1941 and would have unwound fully even without the entry of the United States into World War II. As such, policy tightening was at no point necessary and likely was even responsible for the 1937-1938 recession.

During the period from April 1937 to April 1938 the Dow Jones Industrial Average fell from 194 to 100. Monetarists, such as Friedman, blamed the recession on a tightening of money supply in 1936 and 1937. I don’t believe Friedman’s censure is lost on the FOMC today: past Fed Chair, Ben Bernanke, is regarded as one of the world’s leading authorities on the causes and policy errors of the Great Depression.

But is the size of a CB balance sheet a determinant of the direction of the stock market? A richer data set is to be found care of the Bank of England (BoE). They provide balance sheet data going back to 1694, although the chart below, care of FRED, starts in 1701:-

BoE_Balance_Sheet_to_GDP_since_1701_-_BoE_and_FRED

Source: Federal Reserve, Bank of England

The BoE really only became a CB, in the sense we might recognise today, as a result of the Banking Act of 1844 which granted it a monopoly on the issuance of bank notes. The chart below shows the performance of the FT-All Share Index since 1700 (please ignore the reference to the Pontifical change, this was the only chart, offering a sufficiently long history, which I was able to discover in the public domain):-

UK-equities-1700-2012 Stockmarket Almanac

Source: The Stock Almanac

The first crisis to test the Bank’s resolve was the panic of 1857. During this period the UK stock market barely changed whilst the BoE balance sheet expanded by 21% between 1857 and 1859 to reach 10.5% of GDP: one might, however, argue that its actions were supportive.

The next crisis, the recession of 1867, was precipitated by the end of the American Civil War and, of more importance to the financial system, the demise of Overund and Gurney, “the Bankers Bank”, which was declared insolvent in 1866. Perhaps surprisingly, the stock market remained relatively calm and the BoE balance sheet expanded at a more modest 20% over the two years to 1858.

Financial markets became a little more interconnected during the Panic of 1873. This commenced with the “Gründerzeit” or “Founders” crash on the Vienna Stock Exchange. It sent shockwaves around the world. The UK stock market declined by 31% between 1873 and 1878. The BoE may have exacerbated the decline, its balance sheet contracted by 14% between 1873 and 1875. Thereafter the trend reversed, with an expansion of 30% over the next four years.

I am doubtful about the BoE balance sheet contraction between 1873 and 1875 being a policy mistake. 1873 was in fact the beginning of the period known as the Long Depression. It lasted until 1896. Nine years before the end of this 20 year depression the stock market bottomed (1887). It then rose by 74% over the next 11 years.

The First World War saw the stock market decline, reaching its low in 1917. From juncture it rallied, entirely ignoring the post-war recession of 1919 to 1921. Its momentum was only curtailed by the Great Crash of 1929 and subsequent Great Depression of 1930-1931.

Part of the blame for the severity of the Great Depression may be levelled at the BoE, its balance sheet expanded by 77% between 1928 and 1929. It then remained relatively stable despite Sterling’s departure from the Gold Standard in 1931 and only began to expand again in 1933 and 1934. Its balance sheet as a percentage of GDP was by this time at its highest since 1844, due to the decline in GDP rather than any determined effort to expand the balance sheet on the part of the Old Lady of Threadneedle Street. At the end of 1929 its balance sheet stood at £537mln, by the end of 1934 it had reached £630mln, an increase of just 17% over five traumatic years. The UK stock market, which had bottomed in 1931 – the level it had last traded in 1867 – proceeded to rally for the next five years.

Adjustment without tightening

History, on the basis of the data above, is ambivalent about the impact the size of a CB’s balance sheet has on the financial markets. It is but one of the factors which influences monetary conditions, the others are the availability of credit and its price.

George Selgin described the Fed’s situation clearly in a post earlier this year for The Cato Institute – On Shrinking the Fed’s Balance Sheet. He begins by looking at the Fed pre-2008:-

…the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks’ legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed’s balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed’s immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could  influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Then comes the era of QE – the sea-change into something rich and strange. The purchase of long-term Treasuries and Mortgage Backed Securities is funded using the excess reserves of the commercial banks which are held with the Fed. As Selgin points out this means the Fed can no longer use the federal funds rate to influence short-term interest rates (the emphasis is mine):-

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions’ demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target “range,” because most of the limited trading that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base.

Selgin goes on to describe this as Confiscatory Credit Control:-

…Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases.

The good news is that the Fed can adjust its balance sheet with relative ease (emphasis mine):-

It’s only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills.  Were it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions’ demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks’ own demand for such reserves, both policies are expansionary. They don’t alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks’ capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

Selgin expands, suggesting that if the Fed decide to announce a fixed schedule for adjustment (which they have) then they may employ another tool from their armoury, the Term Deposit Facility:-

…to the extent that the Fed’s gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed’s federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks’ excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.

With unemployment falling and economic growth steady the Fed are expected to tighten monetary policy further but the balance sheet adjustment needs to be handled carefully, conditions may look benign but the Fed ultimately holds more of the nation’s deposits than at any time since the end of WWII. Bank lending (last at 1.6%) is anaemic at best, as the chart below makes clear:-

Commercial_Bank_Loan_Creation_US

Source: Federal Reserve, Zero Hedge

The global perspective

The implications of balance sheet adjustment for the US have been discussed in detail but what about the rest of the world? In an FT Article – The end of global QE is fast approaching – Gavyn Davies of Fulcrum Asset Management makes some projections. He sees global QE reaching a plateau next year and then beginning to recede, his estimate for the Fed adjustment is slightly lower than the schedule announced last Wednesday:-

Fulcrum_Projections_for_tapering

Source: FT, Fulcrum Asset Management

He then looks at the previous liquidity injections relative to GDP – don’t forget 2009 saw the world growth decline by -0.8%:-

Fulcrum CB Liquidity Injections - March 2017 forecast

Source: IMF, National Data, Haver Analytics, Fulcrum Asset Management

It is worth noting that the contraction of Emerging Market CB liquidity during 2016 was principally due to the PBoc reducing their foreign exchange reserves. The ECB reduction of 2013 – 2015 looks like a policy mistake which they are now at pains to rectify.

Finally Davies looks at the breakdown by institution. The BoJ continues to expand its balance sheet, rising above 100% of GDP, whilst eventually the ECB begins to adjust as it breaches 40%:-

Fulcrum Estimates of CB Balance sheets - March 2017 

Source: Haver Analytics, Fulcrum Asset Management

I am not as confident as Davies about the ECB’s ability to reverse QE. They were never able to implement a European equivalent of the US Emergency Economic Stabilization Act of 2008, which incorporated the Troubled Asset Relief Program – TARP and the bailout of Fannie Mae and Freddie Mac. Europe’s banking system remains inherently fragile.

ProPublica – Bailout Costs – gives a breakdown of cost of the US bailout. The policies have proved reasonable successful and at little cost the US tax payer. Since initiation in 2008 outflows have totalled $623.4bln whilst the inflows amount to $708.4bln: a net profit to the US government of $84.9bln. Of course, with $455bln of troubled assets still outstanding, there is still room for disappointment.

The effect of TARP was to unencumber commercial banks. Freed of their NPL’s they were able to provide new credit to the real economy once more. European banks remain saddled with an abundance of NPL’s; her governments have been unable to agree on a path to enlightenment.

Conclusions and Investment Opportunities

The chart below shows a selection of CB balance sheets as a percentage of GDP. It is up to the end of 2016:-

centralbankbalancesheetgdpratios

SNB: Swiss National Bank, BoC: Bank of Canada, CBC: Central Bank of Taiwan, Riksbank: Swedish National Bank

Source: National Inflation Association

The BoJ has since then expanded its balance sheet to 95.5% and the ECB, to 32%. With the Chinese economy still expanding (6.9% March 2017) the PBoC has seen its ratio fall to 45.4%.

More important than the sheer scale of CB balance sheets, the global expansion has changed the way the world economy works. Combined CB balance sheets ($22trln) equal 21.5% of global GDP ($102.4trln). The assets held are predominantly government and agency bonds. The capital raised by these governments is then invested primarily in the public sector. The private sector has been progressively crowded out of the world economy ever since 2008.

In some ways this crowding out of the private sector is similar to the impact of the New Deal era of 1930’s America. The private sector needs to regain pre-eminence but the transition is likely to be slow and uneven. The tide may be about to turn but the chance for policy mistakes, as flows reverse, is extremely high.

For stock markets the transition to QT – quantitative tightening – may be neutral but the risks are on the downside. For government bond markets there are similar concerns: who will buy the bonds the CBs need to sell? If interest rates normalise will governments be forced to tighten their belts? Will the private sector be in a position to fill the vacuum created by reduced public spending, if they do?

There is an additional risk. Yield curve flattening. Banks borrow short and lend long. When yield curves are positively sloped they can quickly recapitalise their balance sheets: when yield curves are flat, or worse still inverted, they cannot. Increases in reserve requirements have made government bonds much more attractive to hold than other securities or loans. The Commercial Bank Loan Creation chart above may be seen as a warning signal. The mechanism by which CBs foster credit expansion in the real economy is still broken. A tapering or an adjustment of CB balance sheets, combined with a tightening of monetary policy, may have profound unintended consequences which will be magnified by a severe shakeout in over-extended stock and bond markets. Caveat emptor.

Yield Curve Control – the road to infinite QE

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Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

  • The BoJ unveiled their latest unconventional monetary policy on 21st September
  • In order to target 10 year yields QE must be capable of being infinite
  • Infinite Japanese government borrowing at zero cost will eventually prove inflationary
  • The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”.  New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited.  This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds.  Zero-coupon bonds are not a joke – 28th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.  

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

  • Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
  • Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

nikkei-share-buybacks-may-2016-goldman-sachs

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.